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Minimum wage and the neoclassical failure of Economics 101

The National Post ran a little pro-and-con debate on minimum wages in Feb. 22's paper. I was the "pro" side; my argument was excerpted from a longer paper on "What determines wages and income distribution" that is available on the CAW's web site. The "con" side was written by two economists at the Fraser Institute.

The Fraser argument was centred in the traditional neoclassical claim that intervening in markets only hurts those you are trying to help. How compassionate of them to care so much about the poor!

Interesting that the Ontario government -- which led the way in Canada, the first province to achieve a $10 minimum wage -- just last week announced the wage would be frozen this year. Bankers aren't getting their pay frozen (bonuses at the Big Six were up to a record $9 billion in the fiscal year ended Oct. 31, 2010). But the hard-working people slinging coffee at Timmie's are.

I recommend the longer CAW paper, if I do say so myself, as an accessible introduction to heterodox thinking about wage determination and income distribution.

Here is my side of today's debate:

Like most economics majors, I was taught early on at university that minimum wages screw up an otherwise efficiently-functioning marketplace for labour. You see, there's a demand curve for labour, and it slopes down. There's a supply for labour, and it slopes up. The two lines cross in the middle, at the sweet spot where supply equals demand.

Now draw the minimum wage: a horizontal line, positioned above the cross. It's plain as day. Too much supply, too little demand, too much unemployment. Well meaning but foolish bureaucrats should leave the market alone to perform its autonomous, masterful balancing act.

The story is simple. It's elegant. And it's wrong. But you have to progress far beyond Economics 101 to find out why. And in the meantime, that simplistic supply-and-demand diagram gets deeply imprinted on too many impressionable minds.

No employer hires labour just for the sake of having workers around. So the fact that labour is cheaper, in and of itself, never guarantees that more will be hired.

Why do employers hire workers? To work: that is, to produce something. Employment is a derived demand, dependent on sales of whatever good or service workers produce. Their employment depends mostly on whether there's enough demand for their output, so that their employers can profitably produce it. That, in turn, depends on a whole stable of economic variables, macro as well as micro -- not least including whether working families have the purchasing power to buy back the stuff they produce.

So, contrary to Economics 101, there's not really an independent demand curve for labour.And the supply for labour cannot be depicted simplistically, either.In fact, labour supply often declines as wages increase (since workers can then afford more leisure time).The two lines don't reliably and stably cross. In fact, it's not clear they cross at all: even where wages are unregulated, unemployment is a normal, permanent feature of the economy. Except under very unusual circumstances (like World War II), labour supply never actually equals demand.

Nevertheless, that Economics 101 story was digested holus bolus by a generation of economists, and minimum wages fell out of fashion.From the late 1970s to the mid 1990s, Canadian minimum wage levels (after inflation) declined by about one-third.

But then a whole new spate of research threw the conventional wisdom deeply into question. Led by U.S. economists David Card and Alan Kruger, the research found no reliable empirical evidence that higher minimum wages produce unemployment. But they found several benefits of minimum wages, including a "trickle-up" effect (whereby many non-minimum-wage workers also got raises); reduced turnover; and higher productivity.

Indeed, in a more complete economic model, there are even circumstances in which higher minimum wages can lead to higher employment. If aggregate demand conditions are chronically weak, the purchasing power created by higher wages can spark a positive and circular process of demand generation, spurring job creation. Similarly, under conditions of "monopsony," where powerful employers can influence wages (rather than accepting a going rate), minimum wage laws can induce higher employment. Employers can then no longer suppress wages (which are now set by law), and hence stop artificially curtailing their hiring.

In practice, the effect of minimum wages on employment is probably a wash. Gradual increases in minimum wages, within reasonable bounds, have virtually no impact on employment at all, in either direction. So long as levels are set realistically relative to productivity and profitability, minimum wages can be increased with no measurable damage to employment.

Perhaps influenced by this recent sea-change in economists' attitudes, policymakers in most provinces have begun to revitalize minimum wages. After years of stagnation, the real purchasing power of minimum wages has increased markedly since 2005, boosting incomes across the lower tiers of Canada's labour market. With business profits simultaneously reaching their highest share ever of Canadian GDP, it could hardly be argued that these modest but important increases squeezed out private sector activity. On the other hand, those higher minimum wages contributed notably to the first real wage gains enjoyed by Canadian workers in a generation.

This successful policy trend should be continued. Minimum wages (now at or near $10 per hour in most provinces) should be increased gradually but steadily in the years to come.

Jim Stanford is an economist with the CAW. This article was first published on the Progressive Economics website.

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